The Hindu Business Line : The limited role of fiction

AS DEPRECIATION allowance under the Income-Tax Act, 1961 was seen as a giveaway, major changes to the law governing the same were made effective from April 1, 1989. The concept of block of assets was introduced and Section 50 laid down that where an asset is granted depreciation, the gain arising out of the sale of such asset will be treated as short term capital gain even though the asset in question would have been part of the block for more than three years. The tax rate applicable to short term capital gains is the same as that for total income.

The concessional rate and benefit of indexation for long-term capital gains tax cannot be utilised by assets on which depreciation is allowed. There can be no substitution of the fair market value in such cases. Section 50 does not refer to fair market value. Adjustments are to be made with reference to the written-down value (WDV) of the asset. If it is a depreciable asset and the assessee had enjoyed depreciation allowance, the cost of acquisition will have to be determined as provided in Section 50.

Is it possible to escape from taxation by investing the sale proceeds of the depreciate assets in specified bonds prescribed under Section 54E? The scheme of exemption under the Section is available to long term capital gains only. Apparently, Section 50 deems capital gains arising out of sale of depreciable assets as gains from short term capital assets. The benefits of Section 54E are available only for transfer of long term capital assets. The object of introducing Section 50 is to deny multiple benefits to an assessee selling a depreciable asset.

According to the Revenue, capital gains on such assets have to be computed under Section 50. And once the section is attracted, the fiction created therein comes into operation and the capital gain is liable to be treated as short term capital gain and, consequently, the benefit under Section 54E will not be available.

This view of the I-T department has not found favour with the judiciary. Section 45 is a charging section and Sections 48 and 49 are the machinery provisions for computing capital gains. Section 50 carves out an exception in respect of depreciable assets. It provides for a different method of computation.

Section 50(2) deals with cases where the block of depreciable assets ceases to exist in that block on account of transfer during the previous year. On transfer of depreciable capital asset, the entire block of assets ceases to exist and, therefore, Section 50(2) is attracted.

The effect of Section 50(2) is that where the consideration received on transfer of all the depreciable assets in the block exceeds the WDV of the block, then the excess is taxable as deemed short term capital gains. That is, even though the entire block of assets transferred are long term capital assets and the consideration received on such transfer exceeds the WDV, the said excess is liable to be treated as capital gain arising out of a short-term capital asset and taxed accordingly. Section 54E makes no distinction between depreciable and non-depreciable assets and, therefore, exemption cannot be denied under Section 54E by referring to the friction created under Section 50. The benefit will be available irrespective of the fact that the computation of capital gains is done either under Sections 48 and 49 or Section 50.

The Revenue's contention that by amendment to Section 50 long term capital assets get converted into short-term capital assets did not find favour with the courts.

The Bombay High Court observed: "The legal fiction created by the statute is to deem the capital gains as short term capital gains and not to deem the assets as short-term capital assets". It cannot be said that Section 50 converts long term capital assets into a short term capital assets (CIT vs ACE Builders Pvt. Ltd — 187 Taxation 222). A similar view was taken by the Gauhati High Court.

In these cases, the courts have gone by the dictum that the fiction created under Section 50 will have a limited role, and should not be extended beyond its scope. There is another view that a legal fiction should be carried to a logical conclusion and one should not be weighed down by the consequences of taking the legal fiction to the logical end.

The Supreme Court, in Common Wealth Trust vs CIT (228 ITR 1), held that the question of fair market value will not arise in cases governed by Section 50.

The two rulings of the Bombay and Gauhati High Courts are favourable to the taxpayer and will help save capital gains tax in respect of depreciable assets. Multiple benefits can still be enjoyed in such cases.

(The author is a former Chief Commissioner of Income-Tax.)

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